Public goods: goods that can be used by the general public, from which they will benefit.

Their consumption can’t be

measured, and thus cannot be charged a price for (this is why a market economy doesn’t produce them). Examples include
street lights and roads.

• National defence. If you protect the country from invasion, it benefits everyone in the country.
• Street lighting. If you provide light at night, you can’t stop anyone consuming the good. Walking under a
street light doesn’t reduce the amount of light for others.
• Police service. If you provide law and order, everyone in the community will benefit from improved
security and reduced crime.
• Flood defences – Protecting the coastline against flooding provides benefits for the whole community.

Merit goods: goods which create a positive effect on the society and ought to be consumed more. Examples include schools
and hospitals.
Merit goods usually have positive externalities; for example, with education, if people gain qualifications –
they can earn a higher salary, but the whole economy benefits from their skills.
Demerit goods is a good where people may be unaware of the costs or choose to ignore them.
Demerit goods often have negative externalities: for example, people may over-consume alcohol or get
addicted to cigarettes – even though this will damage their health as well. If you smoke it gives passive
smoking to others.

Externalities occur when producing or consuming a good cause an impact on third parties not directly related to the
transaction.
• Externalities can either be positive or negative.
• They can also occur from production or consumption.
• For example, just driving into a city centre, will cause external costs of more pollution and congestion to those
living in the city.

External costs (negative externalities) are the negative impacts on society (third-parties) due to production or consumption
of goods and services. Example: the pollution from a factory.

External benefits (positive externalities) are the positive impacts on society due to production or consumption of goods
and services. Example: better roads in a neighbourhood due to the opening of a new business.

Private costs are the costs to the producer and consumer due to production and consumption respectively. Example: the cost
of production.

Private benefits are the benefits to the producer or consumer due to production and consumption respectively. Example: the
better immunity received by a consumer when he receives a vaccine.

Social Costs = External costs + Private Costs

Social Benefits = External benefits + Private benefits

Market Failure

Definition of Market Failure – This occurs when there is an inefficient allocation of resources in a free market.
Market failure can occur due to a variety of reasons, such as monopoly (higher prices and less output), negative
externalities (over-consumed and costs to third party) and public goods (usually not provided in a free market)

Market failure occurs when the price mechanism fails to allocate resources effectively. This is the most disadvantageous
aspect to the market economy. Causes of market failure are:

• When social costs exceed social benefits (especially where negative externalities (external costs) are high).

• Over-provision of demerit goods like alcohol and tobacco: the external costs arising from demerit goods are not
reflected in the market and so they are overproduced.

• Under-provision of merit goods such as schools, hospitals and public transport, since the external benefits of these
goods are not reflected in the market, they are underproduced.

• Lack of public goods such as roads, bus terminals and street lights: since their consumption cannot be measures
and charged a price for, they are not produced by the private sector.

• Immobility of resources: when resources cannot move between their optimal uses and thus are not used to the
maximum. For example, when workers (labour) don’t have occupational or geographic mobility.

• Information failure: when information between consumers, producers and the government are not efficiently and
correctly communicated. Example: a cosmetics firm advertises its products as healthy when it is in fact not. The
consumers who believe the firm and use its products might suffer skin damage.

• Abuse of monopoly* powers: monopolistic businesses may use their powers to charge consumers a high price and
only produce products they wish to, since they know consumers have no choice but to buy from them.

*Monopoly: a single supplier who supplies the entire market with a particular product, without any competition. Example:
public utilities like water, gas and electricity in many countries are provided by their respective governments with no other
producer allowed in the market.
Examples
1. Education
o PC – tuition fees
o PB – higher wages, social status
o EC – negligible
o EB – a more productive labour force, which contributes to economic growth
2. Smoking
o PC – cost of a pack of cigarettes, health problems
o PB – stress relief
o EC – health problems caused by inhaling second-hand smoke
o EB – negligible
3. Pollution (chemical processing plant dumping industrial wastes into river)
o PC – total costs of production (including labour wages, rent, loan interests, etc.)
o PB – revenue generated
o EC – pollution of water, aquatic life harmed, adverse health effects on people who use the water
o EB – employment (jobs) created
 2.1 Market Failure
2.10.1 Definition of market failure

• Market failure – occurs when the free market is left unregulated and fails to allocate
resourcesefficiently

Social = Private + External

Costs: SC = PC + EC
Benefits: SB = PB + EB

• Private costs/benefits – costs incurred by / benefits received by the individuals who are
directlyinvolved in the economic activity of production or consumption (that led to those
costs/benefits)

• External costs/benefits – costs incurred by / benefits received by a third party who is not
directlyinvolved in the economic activity of production or consumption (that led to those
costs/benefits)

• Externality – an external cost or benefit

External costs = negative externalities
External benefits = positive externalities

• Why does EC exist in the equation SC = PC + EC?

EC exists because SC is higher than PC, i.e. SC is more than PC.
A negative externality (i.e. an external cost) exists if the social cost of an economic activity is higher
than the private cost, and vice versa for a positive externality.

• An economic use of resources will raise economic welfare because SB > SC (VS. an uneconomic use
of resources). However, private firms are only interested in profits (PB), so their production
decisionstend to ignore externalities (EC and EB). When private firms are in complete control of all
scarce resources, it’s possible that society will be worse off and SC > SB, and market failure occurs.

Examples
4. Education
o PC – tuition fees
o PB – higher wages, social status
o EC – negligible
o EB – a more productive labour force, which contributes to economic growth
5. Smoking
o PC – cost of a pack of cigarettes, health problems
o PB – stress relief
o EC – health problems caused by inhaling second-hand smoke
o EB – negligible
6. Pollution (chemical processing plant dumping industrial wastes into river)
o PC – total costs of production (including labour wages, rent, loan interests, etc.)
o PB – revenue generated
o EC – pollution of water, aquatic life harmed, adverse health effects on people who use the water
o EB – employment (jobs) created
Disadvantages of the Free Market Economic System (Market Failures)

1. Public goods not provided at all:

Public goods, such as national defence, are not provided at all because they are non-rival and non-
excludable, which gives rise to the free-rider problem. Private profit-motivated firms will fail to
provide public goods since it is impossible to charge for their usage.

(All consumers automatically benefit from the provision of public goods, and market systems cannot
prevent people who refuse to pay from benefitting, so consumers will withhold payment to enjoy the
benefits for free.)

2. Merit goods underprovided:

Merit goods, such as education and healthcare services, are underprovided and under-consumed in the
market system (i.e. less than the socially optimal level). One of the reasons is information failure as
individuals are not fully aware of the long-term benefits from merit goods. Consumption of merit
goods would generate significant positive externalities (e.g. healthcare services make the labour force
healthier and thus increase labour productivity, which contributes to economic growth).

3. Demerit goods overprovided:

Demerit goods, such as tobacco, will be overprovided and overconsumed in the market system if left
entirely to market forces (i.e. charged at market price). People tend to underestimate their costs and
harmful effects.

4. Occurrence of negative externalities:

Negative externalities, such as pollution, occur as private producers disregard the effects of their
production activities on the environment. Pollution is a form of market failure as those not directly
involved in production still suffer from the pollution and its adverse effects on health. Pollution is an
external cost (i.e. negative externality), which occurs when social costs exceed private costs.

5. Emergence of monopolies:
In reality, the market tends to be dominated by a few large sellers and subjected to their exploitation in
terms of high prices and lower output, which undermines consumer welfare. The presence of
monopolies leads to productive and allocative inefficiencies. Producer sovereignty is upheld instead.
Producers have the ability to set prices and decide what, how, and for whom to produce. Producers
also use aggressive advertising to influence consumers.

6. Unequal distribution of income and wealth:

In a free market economy, there is an unequal distribution of income and wealth. Income earned
depends on the value of resources owned by individuals, and prices of resources are determined by the
price mechanism. There is a wide income disparity between the high-income earners, or owners of
highly valued resources, and the low-income earners. The rich starts off rich and gets richer while the
poor remain poor.
Conservation or Commercialisation

• Natural resources are scarce. Should they be conserved, or should they be used / commercialised?

• Conservation of resources
o Avoids rapid resource depletion and environmental damage, which are more
common incommercialisation
o Prevents the loss of natural resources that may beneficial and useful in the future, such
as a specieswith medicinal properties, or areas of natural beauty that can potentially
generate revenue from tourism
o More sustainable growth in the long run
o More of a long-term strategy

o Evaluation → However, the benefits of conservation may be occurring at the expense

of currentgrowth, employment, and standard of living.

• Commercialisation / Use of resources

o Raises output, income, and employment, leading to economic growth and higher standard of
living
o If resources are exported, BOP position would improve
o Resources can also potentially be used to achieve social, economic, and
environmental goalsinstead of being left idle
o More of a short-term measure

o Evaluation → However, commercialisation of resources, if extreme and uncontrolled,

leads to rapid resource depletion, such as overfishing and deforestation. It also harms
the environment andits plants and animals, leading to problems such as pollution,
global warming, and extinction.